Activity-Based Costing

Activity-based costing (ABC) can provide health care professionals with the necessary information to address the critical questions required to manage any organization. ABC is based on the very simple, yet very powerful, principles that activities consume resources and services use the output of these activities. ABC focuses on the management and cost of activities, whereas traditional costing systems focus on departmental or service costs. ABC improves the costing of products and services by more accurately assigning overhead or indirect costs on a cause-and-effect basis.

Activity-based costing is a tool organizations can use to develop more accurate cost information to enhance managerial decision making. Health care costs are going up again. Government officials, corporations, and individuals are all calling for health care organizations to lower costs. Why does everyone appear to be concentrating on reducing costs rather than finding ways to bring in more revenue? In simple terms, if costs are greater than 50% of revenues (as in the current health care environment), organizations receive a greater return on their investment dollar from decreasing costs than from increasing revenues.

Not only is reducing overall costs important, but improving the accuracy of costing information is also becoming much more critical to enhancing organizational performance. Remember: no margin, no mission. As indirect costs (such as overhead) become a larger portion of organizations’ overall costs, it becomes crucial that these costs be allocated accurately. In most cases the information received from the organization's costing systems is of very little value to its managers in making strategic decisions. Organizations have information to satisfy auditors and receive reimbursements (and sometimes even this doesn't work very well), but do they have the requisite information to accurately accumulate what a particular managed care contract is costing? Or how much it is really costing for a particular procedure? In other words, do organizations have the information available to accurately calculate profitability by patient group, procedure, doctor, and insurance carrier? The answer is usually no. ABC can assist in this endeavor.

In addition, traditional costing procedures allocate indirect costs based on some sort of volume measure (encounters, dollar value of reimbursements). When this occurs, the highest-volume (usually lowest-complexity) departments or procedures get allocated the largest percentage of costs, even though this department or procedure may not be actually using (or absorbing) that amount of indirect costs. Therefore, a cross-subsidy of costs occurs, where one department or procedure, although very complex by nature (but low volume), absorbs very little of the indirect costs. [Page 7]These cross-subsidies of service costs can cause all sorts of disrupting behavior in organizations. ABC is a tool to help uncover and correct these cross-subsidies.

How does activity-based costing work? Resources (such as general ledger costs) are first allocated to organization activities (such as locating charts and patient preparation), and these activity costs are allocated to cost objects (such as procedures and insurance carriers). For a simple example, let's assume $1,000 of salary costs. Using time spent, this $1,000 is allocated to the activities actually performed. If 50% of the time was spent performing procedures, 30% of time was spent doing paperwork, and 20% of the time was spent searching for charts, the $1,000 of salary costs would be allocated as follows: $500 to the procedure activity, $300 to the paperwork activity, and then $200 to the searching for charts activity.

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